Good morning, and welcome to Arthur J. Gallagher & Co.'s second quarter 2017 earnings conference call. Participants have been placed on a listen-only mode. Your lines will be open for questions following the presentation. Today's call is being recorded. If you have any objections, you may disconnect at this time. Some of the comments made during this conference call, including answers given in response to questions, may constitute forward-looking statements within the meanings of the securities laws. These forward-looking statements are subject to certain risks and uncertainties discussed on this call or described in the company's reports filed with the Securities and Exchange Commission. Actual results may differ materially from those discussed today.
For reconciliations of the non-GAAP measures discussed on this call, as well as other information regarding these measures, please refer to the most recent earnings release and other materials in the investor relations section of the company's website. It is now my pleasure to introduce J. Patrick Gallagher, Chairman, President, and CEO of Arthur J. Gallagher. Mr. Gallagher, you may begin.
Thank you very much, and good morning, everyone. Thank you for joining us for our second quarter 2017 earnings call. With me this morning is Doug Howell, our Chief Financial Officer, as well as the heads of our operating divisions. As we do each quarter, today Doug and I are going to talk about the four key components of our value creation strategy. Those are, number 1, organic growth. Two, growing through mergers and acquisitions. Three, improving our productivity and quality, and four, maintaining our very unique Gallagher culture. The team really delivered on all four of these strategic priorities this quarter, resulting in excellent top and bottom-line results. I'm extremely pleased with our first half performance, which sets the stage for another outstanding year in 2017. Let me start with some comments on our Brokerage segment. Second quarter all-in organic growth was 4.2%, up nicely over our first quarter.
Through the first two quarters of 2017, organic stands at 3.5%, right in line with the level of organic we experienced last year. Let me give you some granularity around our Brokerage segment organic growth in the quarter. In the U.S., organic growth was about 3.5% for the quarter, with retail growth stronger than wholesale. Internationally, all-in organic was about 5.5% for the quarter, with Australia, New Zealand, Canada, and the U.K. all delivering organic growth greater than 4%. Just a fantastic job by our international team. All of our brokerage operations around the globe grew organically in the quarter, and my optimism for the remainder of the year is based on the broad strength of our operation. As I said in the first quarter, I continue to see full-year 2017 organic growth in our Brokerage segment, similar to 2016's result. Moving to the rate environment.
Our internal data shows global PC pricing down only a point in the quarter, very similar to last quarter. When I look at the first two quarters combined, pricing improved by 50 basis points compared to 2016 within our global retail business. One really interesting observation is in Australia and New Zealand, pricing has really turned and was higher by 4%-5% during the second quarter. By product line, commercial auto is still experiencing the highest rate increases, up about 1.6% within the U.S. during the second quarter. Professional liability is experiencing positive pricing overall, particularly within U.S. wholesale, which was up 2.1%, and U.K. retail was up 1%. The recent rate trends we are seeing in our own internal data were further validated by responses to our annual internal pricing survey, which indicated global PC pricing is down about 80 basis points in 2017.
Further, our mid-year internal rate survey showed almost two-thirds of the respondents expecting no significant change in pricing for the rest of the year. In the end, up a point or down a point, this is effectively a stable pricing environment. Second, let me talk about brokerage merger and acquisition growth. We completed nine tuck-in acquisitions this quarter at a weighted average multiple of about 7x EBITDA. The average size of the nine tuck-ins we completed in the quarter was $3.5 million of annualized revenue. As I look at our internal merger and acquisition report, our pipeline remains full. I see about $250 million of revenue associated with around 40 term sheets either agreed upon or being prepared.
Not all these transactions will close, but we believe we have the right mixture of culture, service capabilities, niches, and tools that will continue to attract talented independent sales and consulting professionals to our organization. As I do every quarter, I would like to thank all of our new partners for joining us, and I extend a very warm welcome to our growing Gallagher family of professional. Third, I want to spend some time on our productivity and quality. Last month, the entire senior leadership team was in London. Now that our large merger integration is essentially behind us, the focus was on the opportunities ahead for our U.K. operation. By leveraging our centers of excellence, streamlining the back office, becoming more efficient on small business, and standardizing processes, we should be able to increase our margins, improve quality, and deliver sustainable organic growth.
It's an exciting time for our U.K. team. To wrap up the brokerage segment, the team posted 9% total adjusted revenue growth on 4.2% organic. Adjusted EBITDA growth of 11% and adjusted EBITDA margin was 31%, up 51 basis points over second quarter 2016. Really strong results sitting here at the halfway mark for our brokerage team. Next, I'd like to move to our risk management segment, which is primarily Gallagher Bassett. Second quarter organic growth was 5.6% and reflects excellent organic growth domestically and internationally. The team has notched a number of new business wins this year across all segments and geographies, many of which were directly with insurance carriers. In terms of merger and acquisition growth, our risk management team completed two acquisitions in the quarter, one in New Zealand and the other in the U.K.
Both of these new merger partners have unique capabilities that will increase and help round out our service offerings in these respective geographies. Risk management adjusted EBITAC margins showed about 10 basis points of year-over-year improvement and fell within our expected range for the quarter at 17%. The team has done really a fantastic job managing headcount as the segment was experiencing lower levels of organic growth over the past couple of quarters. Lastly, culture. Our culture is the key differentiator of our company, we are constantly looking for the right people to join us, whether through new hires, mergers and acquisitions, or our internship program. In August, we will conclude our 52nd year of the Gallagher Summer Internship Program.
This extensive two-month program for over 300 young men and women is an essential investment in our future and is forming a rock-solid foundation for our culture for many, many years to come. Okay, an excellent quarter, a great first half of the year. I'll stop now and turn it over to Doug. Doug?
Thanks, Pat, good morning, everyone. Like Pat said, a really terrific second quarter and first half of 2017. This morning my comments are going to cover some modeling items using the CFO commentary document that we post on our investor website, as well as my typical commentary on margins, clean energy, M&A, and cash and capital management. Okay. First to page two of the CFO commentary. You'll see that most all of the second quarter 2017 actual numbers came in very close to the estimates that we provided during our June 13th investor day. In addition, you'll see that our third and fourth quarter commentary is right in line with what we provided in June also. Really, no new news on page two. Next, please turn to page five of the CFO commentary, to the table showing you roll-in revenues from M&A.
During our June 13th IR day, we provided our updated estimate of $43 million of roll-in revenues. We posted right about that number, $42 million. However, it looks to us like Street Consensus was about $50 million, with some having a much wider range around that number. While $8 million of difference to the consensus isn't a huge number, it does cause about a penny of difference in EPS. We fully understand that making an estimate for rollover revenues is a difficult pick, we will continue to provide an update towards the end of each quarter during our quarterly IR meeting. Meanwhile, please take a few minutes extra when you're updating your models between now and then. Okay, let's move back to the earnings release and some comments on the brokerage segment margins. Adjusted brokerage EBITAC margin expanded 51 basis points in the quarter.
Nearly all of our operating units around the world held or improved margins. A nice, healthy result reflecting strong operational discipline. Natural question might be, why did adjusted margins expand 120 basis points in the first quarter on 2.7% organic, yet expand 51 basis points on 4.2% organic here in the second quarter? It has to do with our seasonality and the roll-in of M&A. First is understanding that our second quarter is by far our highest margin quarter at 31%, versus 24.6% in the first quarter. Second is to understand that the tranche of mergers that are rolling in this year do not have the same second quarter seasonality. In fact, this tranche of M&A rolling in is posting about 25% margins both in the first and second quarter. Accordingly, they didn't really impact margins in the first quarter, and overall, we were at 24.6%.
Here in the second quarter, when overall we're posting 31%, they do bring down margins. If I were to levelize for this in the second quarter, we would have posted about 80 to 90 basis points of margin expansion here in the second quarter. I hope that answers the natural question that might arise. Now looking forward. Last year, the brokerage segment adjusted margins were 27.9% in the third quarter and 25.8% in the fourth quarter. Again, you can see some seasonality there. We posted about 20 to 30 basis points of margin expansion last year in those quarters over 2015. That expansion came on organic of about 3.5% in each quarter. This year, we're targeting similar margins in the third and fourth quarter, so please don't model much of any margin expansion in the second half. Now let's move to our risk management segment.
We posted adjusted EBITAC margin of 17%. As Pat mentioned, the team did a great job of controlling headcount as we move past a lower period of organic growth, but it still resulted in some margin expansion here in the second quarter. We continue to see margins for the full year in the range of 17%-17.5%. Let's turn to clean energy. With a warm June, we had a great second quarter, and our earnings came in at the high end of our estimate. You can see on page three of the CFO commentary that if we hit the midpoint of the full-year range, it will be a nice step up from 2016. Also, I have to say, we all understand that weather can impact those estimates. A cooler summer or a warmer early winter can move our estimates by $1 million.
At June 30, 2017, we have about $550 million of tax credits on our balance sheet, effectively a $550 million receivable from the government. This asset will reduce our future cash taxes paid for many, many years to come, even with or without tax reform. Next, M&A. We're still seeing fair pricing on tuck-in mergers. With a weighted average multiple through June 30th below eight times, it shows that merger partners are choosing Gallagher because they value our capabilities and our culture, and they know that we will be better together. When I look at our pipeline, I see similar pricing for the rest of the year. Finally, cash. At June 30, we're pushing up towards $300 million of available cash on our balance sheet. Combined with the debt offering we announced in June, it looks like we can fund 2017 M&A with free cash and debt.
Those are my comments. Outstanding organics, solid execution on our tuck-in M&A program, excellent operational discipline and margin expansion, and a strong cash position. A terrific quarter and terrific half on all measures. Back to you, Pat.
Thank you, Doug. Operator, we're ready to open up for questions, hopefully some answers.
Thank you. The call is now open for questions. If you have a question, please pick up your handset and press *1 on your telephone at this time. If you're on a speakerphone, please disable that function prior to pressing *1 to ensure optimum sound quality. You may remove yourself from the queue at any point by pressing *2. Again, that's *1 for questions. Our first question is coming from Elyse Greenspan of Wells Fargo. Please go ahead.
Hi. Good morning.
Good morning, Elyse.
My first question is just on the organic outlook, just combined with a broad, I guess more color on the market. As you think to the back half of the year to hit your full-year target would imply maybe just a little bit of a step up from the first half of the year. As you think about that, how are you thinking about organic internationally? Should it remain as strong as we saw in the second quarter? Also, what are you seeing on exposure growth in the U.S., but also around the world?
Well, as it relates to organic internationally, I'm pretty bullish. We've got rate improvement in New Zealand and Australia. Those businesses are doing very well. We've got positive organic in Canada and the U.K. at a level that's greater than the United States, and the U.S. is in very nicely positive organic. I feel that 2017 should look and feel a lot like 2016.
What about exposure growth?
Exposure growth is interesting. It's not having much impact yet, but when I look at the worldwide employment figures, I keep wondering when exposure is going to show some nice shoots, but it hasn't impacted us by more than a percent.
If exposure growth does start to pick up, that would be additive to your organic growth outlook?
Absolutely.
Okay, great. You guys, in the commentary, pointed to flat margins in the brokerage business for the second half of the year. I guess if you continue to hit, say about a 3.5% organic, I know there's some of those acquisitions, Doug, that you pointed to coming in, but why wouldn't you be able to expand margins? Is it just a matter of some investments I know that you've spoken about in the past that you're making within the company?
Yeah. Historically, in the second half of the year, our margin expansion has not been as much in the first half. Thus far, year to date, we're up 84 basis points. We were in a similar position last year at this time. We brought it in right around 50 basis points for the full year. Part of the reason for that is we typically give our raises during the second half of the year. Those will be coming in, so that does have a little bit of a It keeps margins from expanding as much because that's when we give the raises, and then we see the result of that as it rolls in. Basically, like we say, this year feels a lot like last year.
If we end up at 3.5 for the year, if we end up with just a little bit of margin expansion in the third and fourth quarter, we'll bring it in somewhere around 50 basis points of margin expansion on 3.5% organic growth. That's pretty much so how the model works.
In September, is typically when we bring our intern new hires on.
Okay, great. In terms of the weighted average share count went up a little bit in the quarter. Is that due, I think last quarter you pointed out the stock comp accounting, I think raises your share count. Am I thinking about that correctly or is there something else going on there?
Let me clarify on that. The new stock option accounting produces a little bit of a gain in the corporate segment that goes through the P&L now. It used to go through other comprehensive income. It doesn't really impact the number of shares outstanding. The reason why shares are creeping up a little bit right now is we did have more stock option exercises in the first half of the year, that puts more shares out in the market. Our employee stock purchase plan puts them out. That increases it. We did use some shares in M&A this quarter in tax-free exchange, that puts it out. Recall, we purchased those last year. I think we're still about flat when it comes to shares purchased last year versus those shares we've issued in M&A. We pre-bought them.
That's the three pieces that caused the slight creep from, I think we're at $181 million last quarter, and we're pushing $182 million this quarter.
Okay, great. Thanks very much for the color.
Thanks, Elyse.
Thank you. Our next question is coming from Kai Pan of Morgan Stanley. Please proceed with your question.
Hey, thanks. Good morning. Actually, it's Mike Phillips sit in for Kai Pan this morning. Good morning, everybody.
Good morning, Mike.
Good morning. Supplemental contingent commissions looks like they grew pretty well in the quarter. I guess just your outlook on that for the second half of the year, how that varies by quarter and seasonality, and then how much did that impact the margin growth in the quarter?
Yeah. All right. First and foremost, the difference between base and supplemental, I've always said it's a blurry line between that, so I wouldn't read too terribly much into the fact that it grew 10% year to date and base is at 3%, because there is some blurred lines there. I think that contingent commissions are the ones that really have a little bit more impact to the bottom line, and they're up 2.7% in the year to date. It does have a little impact on margin expansion, maybe 10 or 15 basis points by the time you look at after compensation elements that are associated with that.
Okay, great. Thanks. I guess secondly, just more broadly, what impact do you think will have on you guys of the USI Wells Fargo deal, I guess, in acquisition activity and maybe organic growth as well?
Well, I wouldn't comment on what it'll do for organic growth, but whenever there's change in the business and people are looking for another place to maybe rest their head, we try to provide a pretty nice house.
Okay. No major impact. I guess lastly, on clean coal with the sunset coming, just refresh us again on your view of the prospects for tax reform and kind of what you're pursuing other tax credit deals to keep your effective tax rate down.
Great question. I don't really have any views on tax reform at this point. I think it's a crapshoot any way you look at it. I think that regardless of what happens, we have generated a substantial amount of credit carry forwards, $550 million of them, and we'll use those going into the future. We can produce new credits all the way through 2021. By the time we get to that in the current tax environment with our current balance sheet, I don't think that we'd be paying meaningful taxes in the U.S. until late in the 20s. What do we have lined up between 2025 and 2030 for further reductions in taxes? I don't know at this time, but we've been very good over in the history of Gallagher being able to always find some new tax credit strategy. That's something we'll start working on in 2022.
Okay, great. Thanks very much. I appreciate it.
Thanks, Mike.
Yep.
Thank you. Our next question is coming from Adam Klauber of William Blair. Please go ahead.
Thanks. Good morning, everyone.
Good morning, Adam.
A couple different questions. Did I hear correctly, did you say U.S. wholesale rates were up 1%-2%?
On professional lines.
Oh, professional lines. Okay. Well, in wholesale, what's just generally the ballpark, the level of submissions, and how does that compare to a year ago?
Submissions are up nicely, probably up 3%, 4%. Binding, the hit ratio continues to be pretty significant, and the business is very healthy.
Okay. Then how about the benefit business? Is that growing more or less than the overall U.S. retail business?
A little bit more.
Okay.
Not measurably more. Maybe it's 4.5 this quarter versus 4.2 all in.
Okay. I think you mentioned exposures are doing generally okay. How about audit premiums? Are those more of a tailwind today than a year ago?
No, they're not a tailwind. It's kind of flattish. That's kind of the quandary. We're seeing employment figures look strong.
Yep.
I see that globally, yet we're really not seeing payrolls jump, and we're not seeing sales jump. The audits are kind of flattish.
Okay. Thanks. That's all I had.
Thanks, Adam.
Thank you. Our next question is coming from Arash Soleimani of KBW. Please go ahead.
Hi. Thanks.
You're welcome.
Good morning. Couple quick questions. I know you had mentioned that $200 million or $250 million pipeline in the brokerage M&A. Within risk for Gallagher Bassett, I think you said that you had recently hired a full-time M&A person and you didn't have a full-time person in that capacity before. I'm just wondering, given that, how should we think of the pipeline there?
I don't know if we actually said that there's a full-time person inside of Gallagher Bassett. They actually have a team of folks that they're really good about looking for opportunities. Remember, in Gallagher Bassett, what we're looking for is geographic expansion and where our multinational clients would want to have us have places to do business. That's one thing we look for. The other thing is if there are some nice specialty claim related businesses out there that can round out our product offering and offering to our clients. Those are the 2 type of things that we're looking for there. Gallagher Bassett provides a full array of services. They're out there, but there's not an abundance of them.
You're not going to see the kind of the level of activity out of Gallagher Bassett that you see in the brokerage unit. The brokerage world is incredibly fragmented. It's virtually huge, and the opportunities are limitless.
That's not a business where we're just trying to acquire people for a customer list. We do really well on competing every day for that type of business organically. Just to be able to pick up scale through a customer list is not something that's all that interesting to us.
Okay, that's helpful. Thanks. My other question is, within your intern program, how many of those interns typically come on full time?
We have 300 interns this summer, they're split between people who have finished their sophomore year in college and people who have finished their junior year. The juniors will probably be something on the order of 100 out of that 300. They're going back for their senior year. We'll probably recruit about 80 of those that will be starters in September of 2018. By the way, five years later, we'll have 80% of those still with us, and 20 years later, we'll have 80% of those.
Okay, great. Thank you very much for the answers.
Take care.
Once again, ladies and gentlemen, that's star one if you would like to register a question. Our next question is coming from Mark Hughes of SunTrust Robinson Humphrey. Please go ahead.
Yeah, thank you. Good morning.
Good morning.
Any change in underlying claims frequency or severity within the risk management business?
No, not really. Claims frequency is probably up 1% at that. Severity is not showing any real change.
The medical professional liability, you talked about professional lines being up. How about medical professional?
Medical professional is kind of flat.
Wholesale. I think you had in your opening comment that retail was above average, wholesale below average in terms of growth. Is that a change from the recent trend that it decelerated in this quarter?
Look, no, it's been about the same. There's one program in particular in our trucking business that, if you recall, we've talked about this before, that the carriers have kind of come in and out of that, and so we lost our market on it. That pushed us back a little bit. There's markets that are coming back into the space now and pricing is a little bit more reasonable. I would say that we see that. That tends to be a little bit more of a volatile business than, let's say our basic brokerage retail space. When a market comes in and out of a space, it does tend to do it. The last few quarters, the trucking business kind of held us back a little bit on that. Still, posting low single digits is good for that space right now.
Doug, what did you say your available cash was at the-
We're pushing $300 million right now.
$300 million. Okay. Thank you very much.
Thanks, Mark.
Thank you. Our next question is coming from Ryan Tunis of Credit Suisse. Please go ahead.
Hi, this is Crystal Lu in for Ryan. I just had a question on the acquisitions this quarter. The pace of acquisitions seemed to have slowed a little bit. Even though the year to date is basically on pace of a year ago, I thought that the targeted goal was to spend about $800 million on acquisitions this year. Is that still what you're targeting, to spend more than you spent in 2016?
Well, Crystal, this is Pat. Let me address the number of deals, and then I'll let Doug talk about the amount we'll spend on them. The merger and acquisition process is a sales process, just like when we go out and get new accounts. These things, it's not like you get to turn on the spigot and say, "We'll do six this month, and next month we'll do seven." These are entrepreneurs that are selling their baby, and we get that. They're not coming aboard until they're ready, and we've got to do our due diligence. Doing the number that we've done this year is still a very good pace for us, and if it accelerates a little bit in the second half, great. If it slows down a little bit, that's fine, too.
We want to get the right partners on the boat, and we're not just trying to do deals.
No, I think from a cash flow standpoint, we do still see ourselves spending $700 million to $800 million on deals this year, depending if the pipeline develops the way we think it will. We still see a lot of deals in that sub-eight multiple range that we really like, tuck-in acquisitions. If it's a little lower than last year, it wouldn't be by much. If it's a little more than last year, it wouldn't be by much either. Truthfully, if we ended up with a situation where we didn't have so much, maybe we'd buy stock back with that. We'd have to look at what our pipeline would be for the first quarter. Remember, the one thing to remember is that historically, our first half of the year is slower when it comes to M&A than the second half of the year.
Great. That's helpful. The one other question was, I noticed that some of the margin expansion this quarter came from headcount controls. Is this part of something that is a broad initiative that's happening across the company that you think will continue the rest of the year, or is it just something that happens periodically, just one time?
No, we've actually had nice headcount controls for the last couple of years on that. I think as our innovative technologies that we put into the middle office layer come online, it allows us to contract our domestic workforce. We're having very good success with pushing work into our offshore centers of excellence. That's helping us control our headcount. It's just the operational discipline of harvesting the hard work that we've put in over the last decade to become an operationally excellent company, and that's really what's happening. It's allowing us to control the headcount, which is really important. If you get into an inflationary wage environment, that's a competitive advantage for us in that we've proven that our technologies work and that we can control our headcount growth.
Great.
What's interesting is our quality with our customers has gone up dramatically, even during this time.
Great. Thanks so much.
Thank you, Crystal.
Once again, ladies and gentlemen, that's star one to register any additional questions at this time.
I'll just make a few comments and then we'll say thank you for being with us. That's what I'd like to say, is thank you again for being with us this morning. In closing, I'm extremely pleased with our first half performance, and I believe 2017 is shaping up to be another outstanding year. We look forward to speaking with you again in October and having a good second half. Thank you for being with us this morning.
Ladies and gentlemen, thank you for your participation. You may disconnect your lines at this time. Have a wonderful day.